Why Small Businesses Are Ripe for Crowdfund Investing

From the perspective of the federal Small Business Administration (SBA), a small business generally has fewer than 500 employees for manufacturing businesses and less than $7 million in annual receipts for most nonmanufacturing businesses. But from the crowdfund investing perspective, a small business probably earns less than $1 million in revenue and has fewer than five employees. Why the much narrower definition?

Because companies fitting these criteria are the most in need of crowdfund investing support. Historically, businesses with less than $1 million in revenue have a much harder time qualifying for financing than businesses with more than $1 million in revenue.

Why does crowdfund investing focus on small businesses also? Why not just fund startups? One answer is jobs. According to the entrepreneurial think tank the Kauffman Foundation, over the past 30 years, startups and small businesses combined provided the bulk of net new jobs in the United States.

In addition, small businesses that have an operational history may be less risky and more attractive than startups. After all, businesses that have been around a few years usually have a business model that’s working.

Small businesses stand to benefit greatly from crowdfund investing because those businesses that haven’t been around for three years don’t qualify for bank loans (even if they’re growing steadily). And businesses that are growing steadily (5 percent to 20 percent per year) likely don’t qualify for venture capital (because these funders are interested in big exit strategies that deliver a financial return of at least ten times what was invested).

Crowdfund investing is not the right choice for every funding need. If you’re opening or running a small business that likely will never make a significant amount of money, you may not want to get a crowd involved in your business.

After all, having financial obligations or expectations and unhappy investors can be extremely stressful, and investors tend to be unhappy if they aren’t making any money. That stress is very likely to distract you from creating and running your business and will reduce your future productivity.

Technology companies

Technology companies cover a broad spectrum of activities, including (but certainly not restricted to) information technology (IT), green technology, and device technology. What most technology companies have in common is the use of computers and telecommunications to retrieve, transmit, or store information. Social media sites, online shopping sites, and pretty much any application you can get for your iPhone, iPad, or Android fall into this business category.

Other examples might be a new solar panel that can work on cloudy days or a watch that is attached via Bluetooth to your mobile phone.

Many crowdfund investment opportunities will focus on small technology companies. These types of companies are often easy to understand and may have low startup costs (as an example, IT companies may just have to pay for computers and programmers). Plus, depending on how innovative the idea behind the company is, investors may smell huge growth potential.

Bricks-and-mortar retail shops

These types of businesses have an actual storefront. They can be clothing stores, food retailers, or any other businesses that you would walk into to purchase their wares. Traditionally, these businesses have relied upon banks for their capital. Their growth tends to be slower than that of tech companies, and the owners often are happy with just a few branches.

Venture capital and private equity firms don’t invest in these companies because they don’t hold the promise of a huge exit payoff within a less than five-year timeframe.

Before 2008, banks often extended loans to retail shops and accepted their inventory as collateral in case they couldn’t fulfill their debt obligations. But since the financial meltdown of 2008, banks have become much stricter with their loan policies; they require a longer financial history and more collateral. As a result, many bricks-and-mortar shops have been unable to secure financing.

This type of business could be a perfect candidate for crowdfund investing. The risk to investors is much lower than with a tech business, as is the potential payoff. Investments in retail shops or other Main Street businesses may be structured differently from investments in tech businesses as well.

For example, a bricks-and-mortar retailer may offer investors revenue-based financing (RBF), which means the investors are given a percentage of the revenue for a certain time period for a set number of years.

Because the chances of a bricks-and-mortar business going public are very low, RBF is a way that a business can secure the needed capital to grow and the investor can receive a stream of income that varies with the success of the company.

Service companies

The service sector includes people who clean your clothes and serve you meals, as well as lawyers, accountants, doctors, dentists, mechanics, electricians, and so on. Service companies are very likely candidates for crowdfund investment support for two key reasons: They’re among the easiest businesses to start and the hardest to fund.

Why is funding in short supply for service companies? The biggest expense in a service company is usually the employees, and human resources are volatile. (If you invest time and money to train someone, and he walks off to take another job, your investment goes with him.) In addition, investors don’t always see significant return potential from these companies. (How much money can investing in an electrician return?)

Obviously, crowdfund investors face the same issues if they choose to support a service company. But other factors (including knowing and trusting the individual providing the service — something that doesn’t apply to banks and private equity firms) can outweigh the inherent risks involved in financing a service company.